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Understanding, Measuring, and Controlling the total Cost of Quality; The Holy Grail of The Modern Quality System

As a follow up to our Lean article, we decided to continue the discussion of concepts, principles, and tools that aim to reduce operating costs while promoting and improving consumer-centric quality. Among this family of principles are those referred to as quality costing analysis models, or “Cost of Quality” (CoQ) models. Industry has been attempting to meet the challenges of measuring and controlling the total CoQ for the last 60 years and, while the perfect model remains elusive, the search continues. Over this period of time technology advanced, world markets expanded, and it become even clearer that true competitiveness would require successfully meeting customers’ needs with the lowest possible operating costs.

It is clear that the goals of achieving quality, implementing continual improvements, and cutting operational costs are common to modern industry. It is also clear that the approach industry takes to achieve these goals is often limited to the implementation of Quality Systems (activities that ensure quality) and the application of Lean manufacturing principles (to reduce expenses associated to waste).

The unfortunate reality is that another program that shares these lofty goals, quality costing (a program dedicated to understanding, measuring, and controlling the total CoQ), seems to be less widely practiced. In our opinion, the absence of quality costing programs is a function of the difference between systems to track costs of quality (activities), as opposed to those traditionally developed to track the costs of production (expenses).

This article will endeavor to examine benefits that are uniquely provided by quality costing programs while also highlighting their natural interaction with the more commonly used Lean and QMS programs.

Calculation

On the surface it may appear that implementing QMS and Lean tools eliminates the need to implement a method of calculating and controlling the total CoQ but, in my opinion, QMS and Lean neglect the most critical component of the total Cost of Quality calculation.

For instance, utilizing Quality Systems and Lean principles alone to indirectly lower the total CoQ, assumes the following definition of CoQ:

CoQ = Cost of Conformance + Cost of Non-Conformance

Where:

Cost of Conformance = the cost of the systems developed to prevent low quality and/or promote/assure high quality and continual improvement efforts.

Cost of Non-Conformance = all costs that result from poor and/or uncontrolled quality.

Whether you measure the cost in relationship to product or to process, this appears to be right on target, doesn’t it? Right about now, you’re asking yourself;

“What doesn’t this calculation account for?”

“What element could possibly be more critical than either of those?”

Let’s examine those questions.

1. What is covered by these two components?

Costs of Conformance

The costs of conformance include anything and everything that can be associated to the attempt to “do it right the first time.” These are commonly referred to as Prevention and Appraisal (P-A) costs – costs involved in administering systems that have been designed to prevent failure and to measure the output of manufacturing processes.

For example:

requirement definition

specification development

qualification and validation

SOPs

training

quality assurance

quality control

Costs of Non-Conformance

The costs of non-conformance include anything and everything that can be associated to the systems that kick in when something is not done right the first time. These are commonly referred to as Failure (F) costs – costs involved in administering systems that have been designed to respond to and correct internal and external failures.

For example:

more SOPs

problem investigations

CAPA systems and actions

Reworking product

Scrapping product

Recalls/refunds

Re- training

Together, these components of the calculation seem to present a fairly comprehensive list.

In fact, together they do represent a large portion of the costs borne by most industries in the pursuit of quality. In the early days of the CoQ concept, P-A-F models were considered a complete list.

The concept of managing through operational costing analysis first appeared in 1943 when the first dollar based reporting system was widely introduced to industry. In the 1950s this dollar based system was adapted to focus on the economics of quality, introducing the P-A-F categorization of operational overhead to indirectly measure the Cost of Quality.

Since that time, modern QMSs and Lean facilities deal with the P, the A, and the F. After that, it seemed the need to develop mechanisms to directly calculate the total CoQ greatly diminished.

2. What could possibly be more critical?

So what is missing from this equation? Why should we make an effort to directly calculate the total Cost of Quality? The P-A-F model developed in the 1950s appears to account for everything that can be counted, correct?

Correct…

…but not completely correct.

The elements of the cost component not yet accounted for are those that cannot be counted; the intangibles.

Lost Opportunity and Intangible Costs

Modern management theories recognize the importance of identifying hidden costs; those costs that can only be estimated. This component incorporates into our equation all costs attributed to loss of potential revenue and attainable profit that has not been earned.

This list includes, but could never be limited to:

Customers lost as a result of poor quality

Profits not earned due to loss of customers

Reduction in potential revenue

Underutilization of existing capacity

Inadequate material handling

Poor delivery

Extra and aging inventory

Inefficient resource utilization

This resets the older definition of the total Cost of Quality to the following modern, and more direct, calculation:

This equation does not replace the P-A-F elements; it supplements them. We are now attempting to measure the tangible and the intangible elements of the economics of quality. Calculating opportunity based costs can present dramatic challenge, as they are not integrated with industrial accounting systems, which generally attempt to associate costs to products and materials, or to organization units and processes in terms of expenses incurred or projected.

However, there are success stories that incorporate opportunity costs that are equally dramatic.

Take for instance, Xerox, arguably the most impressive resurrection story of the past quarter century. Xerox pioneered incorporating opportunity costs in the determination of CoQ. Rank Xerox, England, used this costing analysis and in the first 5 years realized an 83% reduction in CoQ, 75% reduction in defects and significantly increased customer satisfaction. This case study was reviewed in detail by J. D. Huckett in 1985 (see reference section). A separate publication in 1987 by W. J. Morse (see references) evaluates the same model employed at Xerox HQ in Rochester, NY, realizing a 50% reduction in the CoQ. L.P Carr in 1992 examined use of this program by the US Xerox Marketing group, which reports a record reduction of CoQ by $54 million USD in the first year of its application.

Perhaps the most important study of these intangible costs was performed by C. D. Heagy in 1991, who asserted that seeking the obvious benefits is not as important as avoiding the less obvious dangers.

Heagy’s list of dangers presented by the older calculation includes:

Poor decision making with regard to the funding of quality systems

Degradation of corporate image

Perception of market inferiority

This work and others note that studies have shown:

Companies that are perceived to have a higher quality product are 3 times more profitable than those that are not, and

Companies can boost profit by almost 100% by realizing only a 5% increase in customer retention

It is clear when reviewing the body of research done on this topic, that there is no way to underestimate the criticality of identifying/estimating opportunity costs when attempting to calculate, so that you can control your organization’s CoQ.

Implementation

Even when the method of calculating the CoQ (P-A-F or P-A-F-O) has been agreed upon within an organization, the challenge of determining an implementation plan remains. Current models used to measure and control the CoQ represent as wide a variation as do types of industries and types of organizations within industries. Implementation strategy will depend heavily on the calculation utilized, and the unique operating elements of each company. The presentation of advice on the practical application these models could be an entire series of articles, which perhaps we will publish someday.

Until that time, the following list presents some fundamental truths to be considered when developing an implementation plan:

CoQ models cannot be replicated from a success story, they must be tailored with regard to the unique aspects of each company.

The components of the model must integrate with the company’s financial systems so that they can be expressed in dollar values.

The financial systems must be adapted to understand how to associate cost to activities and not only to expenses.

The model must be based on continual improvement concepts.

The implementation plan must include definition of expected feedback loops with varying levels of detail and include development of components to receive and process that feedback.

The model must understand the targets for improvement, or at least be used for a defined period of time to identify the areas for improvement and then be adapted to target those areas.

Conclusion

Cost of Quality measurement models should be a component of every Modern Quality System. Their integration with Lean and Six Sigma tools is a natural evolution of practices whose theories share a common foundation:

Optimization of quality

Continual improvement

Reduction of waste and cost

There are no turnkey solutions when it comes to implementing a system that will account for all of the costs of Quality. The methods and models currently in use are variable and must be developed, or at least adapted, for each situation and environment. But they are not overly complex, and there are many well respected publications to provide guidance. Exposure and education to the concepts are generally all that is needed to begin system development and implementation efforts.

Finally, it is clear that quality is something we all strive for, and quality has a cost. Developing a strategy for measuring what quality costs your company is the only way to reduce that cost, while maintaining the quality of product and retaining customers.

Those companies who do it well and have the gained the competitive advantage over those that have not.